John Betteridge: Two out of three ain't bad

The recent coincidence of a return to the black for the S&P and the gloomiest ever predictions from the Organisation for Economic Co-operation and Development (OECD), World Bank and the Federal Reserve seem to emphasise the disconnect between equities and economic outlooks. Lots of shouting but no listening. Both parties can't be right, so for now, they are going their own separate ways.

We saw the deep economic dislocation that would occur as a result of Covid-19 lockdown measures, the likely quantum of policy response, but not the seemingly perverse reaction of equity markets (Figure 1). It does not feel good at all. Two out of three is not enough! We strive for better.

Figure 1: S&P 500 year to date

Source: Refinitiv, Rowan Dartington Research

In April, the International Monetary Fund (IMF) was the first supranational agency to publish economic forecasts. Their estimates of global Gross Domestic Product (GDP) growth were for a contraction of 3% in 2020. We have now seen a number of other supranational agencies produce post Covid-19 forecasts, notably the World Bank and the OECD.

Two months on, and economists are way more pessimistic about the future. The OECD is the most bearish, forecasting a drop in 2020 GDP growth of between 6 and 7.6%. The World Bank is in the middle at a decline of 5.2%. The trend seems clear, however.

The IMF forecasts were also more "V" shaped in their profile, with a sharp contraction seen in 2020, followed by a strong recovery in 2021, albeit not quite enough to recover all the lost output, but also not too far away either. They emphasise the downside risks to their numbers, and the possibility that "recovery" of that lost output will likely be a multi-year event, extending beyond 2021. These forecasts should not be equity market friendly in any way at all.

Perhaps the most obvious point to make about all these forecasts is the depth of the global recession. Compared to the last downturn, these forecasts are suggesting a forthcoming recession between two and four times the magnitude of the last one. Not only that, but the chronology of these forecasts implies that the more economists learn about the economic impact of lockdown, the more pessimistic they become about economic growth prospects. There is no sugar coating it: the top-down outlook for economic growth is dire and getting worse.

Figure 2: World GDP growth (%) with forecasts

Source: Refinitiv, Rowan Dartington Research

Top down economists are predicting the worst recession in living memory and bottom up company analysts' have remained rather more sanguine (Figure 3). This may be where part of that disconnect originates. This suggests to us that the process of downgrades is far from over, and that the next earnings season may provide the catalyst for further revisions.

There is another strand of information in the analysts' forecasts that may provide a clue about the likely profile of corporate earnings. That is the difference between the 1-year and 2-year forecasts in these numbers. In both previous recessions, the downgrades to EPS growth were symmetric, with roughly the same degree of revision to both numbers as analysts saw the recession as a multi-year event.

 This time, downgrades have disproportionately hit the near-term expectations (down 25%) leaving the year 2 forecasts (down 12%) relatively unscathed. Could it be that analysts are forecasting a deep but very short recession, front loading earnings recovery into the back end of this year rather than next? If that is the case, then they will be very sensitive to "second wave" news flow, and Doctor Anthony Fauci seems to be the bearer of bad news.

Figure 3: Analysts' EPS forecasts, year 1 and year 2

Source: Refinitiv, I/B/E/S, Rowan Dartington Research

There may be something more basic at work, however. Recent experience has shown us that recessions unfold gradually, and equity markets adjust valuations over a similar time frame. In Figure 4 we have plotted the S&P 500 from the cycle peaks of 2000, 2007, against the progress so far from the 2020 peak forward 500 trading days.

The last recession was priced into equity markets over the course of a year and a half. The dot com crash took longer still. Why would we expect equity markets to have fully, and accurately appraised the necessary valuation adjustment to Covid-19 in just over a month?

That seems rather unlikely, particularly given that economists (and analysts) have continued to revise down their expectations on the news flow through this crisis. It seems likely to us that the process of adjustment is not yet over. We do not want to get too bearish, but this equity market adjustment process may even continue into next year if the previous two examples are anything to go by.

Figure 4: S&P 500 previous peak to trough

Source: Refinitiv, Rowan Dartington Research

John Betteridge is chief investment officer at Rowan Dartington

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